Funding innovation – a broken cycle?

Without a doubt, Clayton Christensen is one of the most prolific thinkers, scholars, and writers on innovation. He is probably best known for having coined the term “disruptive innovation”, but that is only the tip of the iceberg. To get a deeper appreciation of his thinking, I’d encourage you to watch the Clarendon Lecture he gave at Said Business School in Oxford in June last year, where he sketched his theory of economic growth. Christensen builds his theory around three types of innovation: disruptive, sustaining, and efficiency innovations. Let’s see.

Disruptive innovation makes a product or service accessible for a larger number of customers. Christensen had previously labelled this type empowering innovation, as it provides a functionality of a formerly exclusive product to a wider customer base. As an illustrative example, take the shift from mainframe computers to Personal Computers. It is evident that the first PCs could only deliver a few of the basic functionalities that mainframes would offer. But they opened the gate for personal computing to millions of private and business customers who could neither afford nor otherwise get access to mainframes. By empowering this new group of customers, PCs significantly enlarged the market for computing. Supplying this larger market required capital investment to increase production facilities, which in turn created jobs. And that’s the macro-economic magic of disruptive innovations: they consume capital to generate jobs.

Sustaining innovation replaces an existing product or service with a new version that provides some additional functionalities. Think about the now seventh generation Volkswagen Golf. It’s improved over its predecessor in many aspects. But because the price is likely to change little, the new Golf is not more easily affordable then the previous version. Consequently, the numbers of units sold or of customers served don’t change drastically. Rather, sustaining innovations position a product line to compete for a larger market share, without effecting the market size itself. They are a means to compete within a given market, and their effect on jobs and capital is fairly limited. Shifts will occur, as one manufacturing plant might close down and another one is opened, so that jobs and capital are moved from one location to the other. But the overall volumes of jobs and of capital investment will essentially remain unchanged.

Efficiency innovation delivers the same product or service at a lower cost. You might have observed that yourself if you know Ikea’s Billy bookcase. Over the more than thirty years of production, while the basic functionality remained entirely unchanged, many of the individual Billy components were replaced, for example to become lighter (thinner back) or to consume less expensive material (less metal parts).  Efficiency innovations are the means for the producers to increase their margins for the very same products. Essentially these innovations focus on optimising business processes, be it in management or in production. This approach is of course entirely in line with the micro-economic logic of minimising production cost. But is has significant macro-economic effects, as it kills jobs and releases capital.

And that’s where Christensen sees a closed cycle. In an ideal world, these three types of innovation  keep the big wheel of economic growth turning. Efficiency innovations release the capital necessary to invest in disruptive innovations. And the jobs suppressed by efficiency innovation will, at least in gross numbers, be replaced with the new jobs created by disruptive innovation. Economic growth is generated all the way through, by increasing margins (efficiency innovation), by increasing market share (sustaining innovation), and by increasing market size (disruptive innovation). And as long as the wheel keeps turning, the disruptive innovations of each cycle will increase the potential for further growth through sustaining and efficiency innovations.

While the economic history since the Industrial Revolution seems to have worked very much as assumed by this model, Christensen concedes that in today’s reality the wheel is broken. The major focus is now on efficiency innovations, and the capital released is reinvested in yet more efficiency innovations. Again, this approach follows a micro-economic logic to invest only in low-risk opportunities that guarantee short-term return on investment. Christensen stresses the fact that this is in no way a sign of bad management; rather, it’s management according to the book, doing what MBAs have been trained to do.

Yet at the macro-economic level, today’s emphasis on efficiency innovations causes significant damage. First, the capital released by previous efficiency innovations is not invested in disruptive innovations.  As a consequence, the good ideas that could increase the overall market size remain unfunded, hence cannot take off. Second, the workforce released by efficiency innovations cannot be absorbed by the jobs that properly resourced disruptive innovation would have created. Finally, and most importantly, without the next round of disruptive innovation, overall market size will remain unchanged, thus limiting the potential for future economic growth to “only” that growth that sustaining and efficiency innovations can generate. The underfunding of disruptive innovation we observe today does not simply result in unemployment; more importantly it severely constrains the potential for our future economic growth.

Christensen contrasts today’s focus in efficiency innovation with what he refers to as Gilder’s Axiom, basically saying that scarce resources must be handled with utmost care, whereas abundant resources may well be wasted. Seen through this lens, the MBA textbook logic of investing capital only into low-risk short-term opportunities did make perfect sense in the past, when capital was a scarce resource. Ironically, as a result of the systematic application of that logic, its very foundation is eroded so that capital nowadays has become abundant. Therefore, and now contrary to current textbook wisdom, capital should be poured into high-risk investments, without too much concern over a guaranteed short-term return. That would get the big wheel back into full cycle. However, it’s the business economics textbooks that got us to where we are today, and what is more,  they neither suggest an alternative approach to teaching micro-economics nor do they see such a need.

I’d suggest that two lessons should be drawn from this. The first is on economics and the reality that the strict application of micro-economic logic does not automatically guarantee results that are macro-economically desirable. Christensen in his lecture offers a number of hints at the unhealthy role that key performance indicators can play. In teaching micro-economics, efficiency orthodoxy should meet with Gilder’s Axiom and an understanding for the role of disruptive innovation. That approach would achieve a more comprehensive education for future business executives.

The second lesson is on innovation literacy. Exactly because business executives do not always have a full appreciation of innovation, the innovators themselves must develop their own broad understanding of the role of innovation in generating economic growth. We do need a two-way translation, and both sides have to contribute to its success. While business people need to learn that innovation has timelines deviating from their short-term perspective, it’s on the innovators to fully comprehend their investors’ interests.

Ultimately, and only after both sides learned each others’ languages, they’ll be able to collaborate in a mutually beneficial way. Only when capital and ideas go hand in hand and join their forces can society progress.

 

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